Trading the S&P 500 With a Simple Chart
Any beginners investor has learned about the S&P 500, or at least heard the term. The S&P 500 is an index that tracks the stock performance of the top 500 companies on the U.S. stock exchange. For this example on stock charts, we’re going to look at the S&P 500.
Chart patterns show traders’ emotions. This is a picture of collective emotions of the group of people involved in the stock market. That’s consistent with the efficient market hypothesis (EMH).
Under the EMH, the current price reflects the collective wisdom and actions of all market participants. No single individual knows everything about the market. But as a group, everyone’s action reveals the correct price in the sense that the market price is where the forces of supply and demand are balanced. [1]
Price charts display the movement of the collective decisions.
Earnings Show How Charts Reflect Emotional Responses
Earnings reports offer an excellent example of how the EMH looks in action and how that plays out on a chart.
Current prices reflect all known information according to the EMH. Earnings represent new information and the market price should react to the information. That often results in a large one-day price move. Recent earnings from Intel (Nasdaq: INTC) offer an example of this process as shown in the chart below.
Source: Optuma
In the days before the announcement, the stock traded in a relatively narrow range as traders waited for the announcement.
In the announcement, the company’s management provided reasons for traders to become more optimistic. This resulted in a rapid advance in the stock. The market price incorporated that news almost instantaneously.
After the announcement, the stock settled into a relatively narrow trading range again as traders awaited new information about the company.
This entire process unfolded in line with the behavior of stocks postulated in the EMH. The price chart merely documents the behavior but can be interpreted in light of the theory.
Interpreting the Current Market Action
Using a behavioral focus, it’s possible to look at charts in a new light. The chart isn’t providing unique information, it’s simply allowing us to visualize the collective psychology in the stock market. Based on the psychology, we can then develop a trading plan.
The chart of the SPDR S&P 500 ETF (NYSE: SPY) is shown below.
Source: Optuma [3]
In the chart, the trend is up simply because the prices on the right side of the chart are higher than they are on the left side of the chart. This is a simple approach, but charts only provide enough information for a simple analysis.
A trend remains in place until the evidence of reversal is decisive. In this case, the uptrend is intact until prices break under the low of the recent consolidation pattern. That pattern is highlighted with a rectangle in the chart.
While the trend will not formally reverse until they fall below the lower limit of that recent consolidation, there is no need to wait until that happens. If prices fall below the midpoint of the rectangle, it’s reasonable to expect them to continue lower.
Closing a position on that signal could save traders a couple percent if the uptrend is actually over. If it’s not actually over and prices turn up again, the upper edge of the rectangle provides a reentry point.
Remember that charts reflect information available to traders. The recent consolidation came as news about the coronavirus was breaking. The up move in SPY coincides with diminished concerns about the virus. A downtrend would reflect new fears about the virus.
The value of charts is that they provide a trading plan. There is no need to find targets when it’s possible to simply decide whether the trend is up or down. With that knowledge, and only that knowledge, traders have enough information to make a trade. An exit price can then be determined on the chart and the exit price can be trailed higher if the market moves higher.
While many investors have a negative opinion of charts, the simplicity of charts and the fact that they summarize so much important information makes them useful.
You just have to know how to use them, or find a stock advisory service that can help you along the way.
Regards,
Editor, Peak Velocity Trader
Sources:
[1]:Morningstar Investing Glossary, Efficient Market Hypothesis — https://www.morningstar.com/InvGlossary/efficient_market_hypothesis_definition_what_is.aspx [2]: Optuma — https://www.optuma.com/research/ [3]: Optuma — https://www.optuma.com/research/
After spending nearly 20 years developing pattern recognition software for the United States Air Force, I retired from my military career in 2005. My plan was to utilize the same pattern recognition principals I used in the military and apply them to the largest and most lucrative market in the world: the stock market.
